Is crowdfunding a viable source of MSME funding?

Securities market regulator Sebi (Securities and Exchange Board of India) has been trying to get a handle on digital platform-based crowdfunding since at least 2014, when it issued a cautiously positive consultation paper. It flipped its stance in September last year, warning investors to stay away from digital equity crowdfunding platforms. It has moderated its stance since, moving to finalize regulatory norms. Those are likely to be released soon. But the details that have been reported thus far point to the difficulty of resolving crowdfunding’s central tension between protecting retail investors and keeping regulatory costs low enough to make capital access viable.

There are currently two crowdfunding models that are of interest to regulators. The equity-based model allows for a stake in the venture via private placement. And peer-to-peer (P2P) lending, which falls under the Reserve Bank of India’s (RBI’s) purview, connects lenders and borrowers who may mutually agree upon either a fixed interest rate or a variable one. Both operate via third-party digital platforms.

Some of the potential benefits of equity-based and P2P crowdfunding are apparent. They allow start-ups and small enterprises that may not have been able to access venture capital or credit from the formal banking system to acquire funding, spurring innovation and entrepreneurship. This is particularly pertinent given the preponderance of MSMEs (micro, small and medium enterprises) in India.

Other benefits are less obvious. In a 2016 paper for the US government’s small business administration, Research On The Current State Of Crowdfunding: The Effect Of Crowdfunding Performance And Outside Capital, Venkat Kuppuswammy and Kathy Roth found that crowdfunding success served as proof of concept and made it easier to subsequently access capital from more traditional sources such as banks, venture capitalists and angel investors.

It also “resulted in higher levels of business partnership, greater publicity, a stronger customer base, and an easier time finding employees”. Most intriguingly, crowdfunding has the potential to bypass lack of access—often due to caste or gender prejudice—to the trust-based community networks that underlie India’s business networks.

The immaturity of digital crowdfunding globally and the start-up sector in India mean that these come with plenty of caveats, however. This newspaper has warned of the start-up bubble, fuelled by multiple factors. Crowdfunding could be another one of those. Venture capital (VC) comes paired with institutional expertise in making the right wager—and outside the top funds, still has a poor rate of success. Small investors lacking that expertise could funnel capital to unviable enterprises. Then there is the problem of credit- worthiness and enforceability, home-brewed credit ratings provided by digital platforms notwithstanding. Fraud and money laundering are risks as well. P2P lending company Ezubao’s bilking about 900,000 investors over $7.5 billion in China in 2015 is a case in point.

Caution on the part of Sebi and RBI—which also issued a consultation paper on P2P lending last year and is soon to announce guidelines—is thus warranted. And to be fair, reports indicate that the RBI’s guidelines are shaping up to be reasonable: from mandating Rs2 crore capital for lending platforms to ensuring that funds move directly from lender bank account to borrower bank account in order to rule out money laundering.

Sebi, however, seems to be missing the mark. Some appropriate measures are on the anvil, such as exempting crowdfunding activities from the Companies Act’s private placement norms that mandate a private company making a public offer if the number of investors is 200 or more in a year. Other measures such as a minimum threshold of stake purchases and prior approval for access to equity crowdfunding platforms are aimed at restricting the field to large firms and institutional investors. This subverts the idea of crowdfunding.

And it doesn’t pair well with the peculiarities of the Indian start-up sector. Globally, VC funds tend to flow into later stage, proven companies. In India, they are focused on early stage and seed deals. As per YourStory Research, 67.9% of the start-up financing deals in 2016 were in the pre-series stage. Series A deals accounted for just 9.8% while Series B deals were 5.1%. Sebi’s proposed norms thus restrict early stage and seed deals to big investors who are already focused there regardless. And they lock smaller retail investors out of the later stages where there is a paucity of funding.

Such initial hiccups are understandable given the difficulty of finding the right balance. Besides, the crowdfunding industry is at a relatively nascent stage. But it is growing rapidly; the global P2P industry has doubled in size every year over the past five years. More regulatory tinkering and evolution is needed as the industry grows in India as well.